LONDON - All economies recover in the end. The question is how fast and how far. When Keynes talked of persisting ‘under-employment’he did not mean that, following a big shock, economies stay frozen at one unchanging level of under-activity. But he did think that, without an external stimulus, recovery from the lowest point would be slow, uncertain, weak, and liable to relapse. In short, his ‘under-employment equilibrium’ is a gravitational pull rather than a fixed condition. This is a situation which Alan Greenspan has aptly described as a ‘quasi-recession’, a better phrase than ‘double-dip recession’.It is a situation of anaemic recovery, with bursts of excitement punctuated by collapses. It is the situation we are in today.
Contrary to Keynes, orthodox economics believes that, after a big shock, economies will ‘naturally’ return to their previous trend rate of growth, provided that governments balance their budgets and stop stealing resources from the private sector. The theory underlying it has been explained in the July Bulletin of the European Central Bank. Debt-financed public spending will ‘crowd out’ private spending either if it causes a rise in real interest rates or if it leads households to increase their saving because they expect to pay higher taxes later. In these cases a fiscal stimulus will not only have no effect; the economy will be worse off because public spending is inherently less efficient than private spending.
The Bulletin’s authors do not believe that such complete ‘crowding out’ actually happened in the last two years. They explain why.If there are unemployed resources, extra government spending can ‘crowd in’ in private spending by creating additional demand in the economy which would otherwise not be there. Summarizing the evidence, the Bulletin finds that fiscal stimuli in the Eurozone have caused Eurozone GDP to be 1.3% higher over the period 2009-2010 than it would otherwise have been.
The evidence of a positive effect is even stronger for the United States. In a recent paper, economists Alan Blinder and Mark Zandl find that the total stimulus policy adopted in 2009-2010 (including TARP) averted another Great Depression. Fiscal expansion alone (to make the direct comparison with the ECB Bulletin) caused US GDP to be 3.4% higher over 2009-2010 than it would otherwise have been.
However the cutters have a fall-back position. The problem with fiscal stimuli, they say, is that they destroy confidence in the finances of the governments undertaking them, and this lack of confidence impedes recovery. So a credible deficit reduction programme is now needed to ‘consolidate’ recovery’.
What is it about cutting the deficit which is supposed to ‘restore confidence’. Well, it‘may’ lead consumers to believe that a permanent tax reduction will also take place in the near future. This will have a positive wealth effect and increase private consumption. (This is known as the expansionary fiscal contraction hypothesis.) But why on earth should consumers believe that cutting a deficit, and raising taxes now, will lead to tax cuts later on?
One implausible hypothesis follows another. Fiscal consolidation, the Bulletin says, ‘might’ lead investors to expect an improvement in the supply-side of the economy. But It is unemployment, loss of skills and human self-confidence, and investment cancellations that hit the supply side.
We are told that the ‘credible announcement and implementation’ of a fiscal consolidation strategy ‘may’ diminish the risk premium associated with government debt issuance. This will reduce real interest rates and make the ‘crowding-in’ of private spending more likely. But real interest rates on long-term government debt in the USA, Japan, Germany, and the UK are already close to zero. Not only do investors view the risks of depression and deflation as greater than those of default, but bonds are being preferred to equities for the same reason. Finally, the reduction of government borrowing requirements ‘might’ benefit output in the long-run from lower long-term interest rates. Of course, low long term interest rates are necessary for recovery. But so are profit expectations, and these depend on buoyant demand. However cheap it is for businessmen to borrow, they will not do so if they see no demand for their products.
These Bulletin arguments look to me like scraping the bottom of the intellectual barrel. The truth is that it’s not the fear of government bankruptcy but governments’ determination to balance their books which lowers business confidence, by reducing expectations of employment, incomes, and orders. It’s not the hole in the budget but the hole in the economy which is the problem.
Let us assume, though, that the ECB is right and that fears of ‘unsound finance’ are holding back the recovery of the economy. The question still needs to be asked: are such fears rational? Are they not grossly exaggerated in the existing circumstances (except, possibly in countries like Greece)? If so, is it not the duty of official bodies like the European Central Bank to challenge irrational beliefs about the economy rather than pander to them?
The trouble is that the present crisis finds governments intellectually disabled, because their theory of the economy is in a mess. Events and common sense drove them to deficit finance in 2009-2010, but they have not abandoned the theory which tells them that that depressions cannot happen, and that deficits are therefore always harmful (except in war!). So now they vie with each other in their haste to cut off the life-line which they themselves created. Policy-makers need to re-learn their Keynes, explain him clearly, and apply him, not invent pseudo-rational arguments for prolonging the recession.